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Travelers still on the road to St Paul

Both sides insist the merger is on schedule to complete in the second quarter and were vocal in their public endorsement of the deal.

St Paul chairman and CEO Jay Fishman (himself a former Travelers chief) confirmed: "We continue to be tremendously excited about the announcement in November 2003 of our plans to merge with Travelers… We have made substantial progress in preparing for the merger, including the appointment of executive leadership and senior management for the combined organization."

Fishman's counterpart at Travelers, Robert Lipp, commented: "We have identified a strong management team at both the senior and field levels, are well down the road in analysing systems integration needs, and are proceeding as planned in our regulatory submissions and reviews."

As reported in the November 2003 issue of The Insurance Insider, consummation of the merger will create the second largest US commercial lines insurer behind AIG, with the amalgamation of $107bn total assets, $20bn of shareholders' equity, $26bn in capital and net written premiums of $20bn.

The new combine will be known as The St Paul Travelers Companies, with Travelers surrendering head office rights to St Paul's Minneapolis base and St Paul's international business staying put in London. The deal will create a mammoth joint executive board, with 12 Travelers directors joined by their 11 counterparts at St Paul. Fishman will take the post of CEO and Lipp will chair the merged company.

Both companies will seek shareholder approval at special meetings to be held on 19 March, with joint prospectuses posting out early this month. Under the terms of the transaction, Travelers stockholders will receive 0.4334 St Paul ordinary shares for each of their own.

Deal worth $18bn
At the time of going to press, based on St Paul's share price of $42.13, the agreement values each Travelers' share at $18.26, just above the Travelers' close of $18.10. With just over a billion Travelers' shares outstanding, the stock swap is currently worth around $18bn.

But industry observers continue to question the rationale behind a deal that seems to be of greater benefit to St Paul than Travelers. Indeed, Standard & Poor's announced it will probably downgrade Travelers' rating to the level of St Paul on successful completion of the merger, of which more later.

On 23 January, Minneapolis based St Paul preannounced its fourth quarter 2003 financials, revealing a higher than expected $350mn pre tax charge for deterioration on its healthcare business in run-off.

In its full earnings release a week later, the insurer announced it had booked operating earnings of just $9mn in the quarter, equivalent to 2 cents a share, compared to $194mn, or 91 cents per share in the fourth quarter of 2002.

In addition to the healthcare reserve charge, St Paul revealed a further $196mn of charges for IBNR (incurred but not reported) asbestos claims, uncollectible reinsurance and other losses.

For the year as a whole, the picture looked better. Net income for 2003 came in at $661mn, more than treble the $218mn total for the previous year and including net realized investment gains of $79mn, a loss from the cumulative effect of an accounting change of $21mn, and losses in discontinued operations of $17mn.

Fishman said: "Our performance in 2003 continued to reaffirm the strategic course we set in late 2001. Our ongoing businesses produced strong and improving results, thanks to our continued focus on profitable growth, disciplined underwriting and expense consciousness. However, losses in our runoff businesses dampened overall insurance underwriting results."

The strategic course launched in 2001 included exiting medical malpractice, shedding unprofitable segments from the group's international business, exiting some reinsurance lines and cutting corporate overheads. The group's ongoing reinsurance business was transferred to its part-owned Bermudian start-up Platinum Underwriters in 2002.

Total net earned premiums were down 6.2 percent on 2002 to $7.04bn as premiums from run-off business continued to wind down. Net written premiums rose 5.6 percent to $7.54bn compared to 2002. And commercial lines and specialty commercial - the group's ongoing business - reported net earned premiums of $6.71bn for 2003, up 21.5 percent on 2002. Combined net written premiums grew to $7.22bn for the lines, an increase of 23.6 percent on the previous year.

Combined ratio in ongoing business improved from 95.8 percent in 2002 to 91.7 percent in 2003. The results signal a positive trend, with two years in the black following 2001's devastating $1.1bn net loss.

Mixed reception
Analysts and rating agencies had mixed views on the results. Todd Bault at equity house Bernstein said St Paul estimates would be raised from $4.30 earnings per share (EPS) to $4.40. But questions were raised over the sustainability of a 92 percent ongoing combined ratio performance, in the light of slowing commercial pricing.

William Wilt, part of the Morgan Stanley's insurance team, said: "From an operating perspective, we see SPC (St Paul) as performing well in this late stage of the hard insurance market. However, its 2004e operating ROE of 16 percent and 18 percent is only in line with its peers. Meanwhile, most measures of operating and financial leverage reveal consistent weakness relative to peers."

"With lower financial flexibility, rating agency pressures (again), a waning hard market, and valuation at 1.5x - above its historical average - we think SPC has grown increasingly dependent on the consummation of the planned merger," he continued.

Fitch responded to the results by cutting the group's long-term and senior debt ratings from BBB+ to BBB because of concerns over reserve adequacy. The agency said that it would probably upgrade ratings again on completion of the merger.

AM Best lowered its outlook on financial strength and debt ratings from positive to developing after the initial charge was announced, due to its unexpected magnitude resulting in "weaker than anticipated, although still strong, capitalization".

S&P took the same tack, lowering the rating outlook to CreditWatch Negative. "The more negative view of St Paul's stand-alone financial strength reflects concerns about the adequacy of loss reserves associated with runoff operations, reserves for business written in the soft market years of 1998-2001, and asbestos exposure," said credit analyst John Iten.

Travelers downgrade
If the merger goes through though, S&P said St Paul ratings would stay at A+. Crucially for Travelers, this would involve a downgrade from its current rating.

Standard & Poor's confirmed this by releasing a statement suggesting that on completion of the merger with St Paul, it expects to downgrade all long-term ratings on Travelers entities by one notch. This would align counterparty credit and financial strength ratings with St Paul at A+, and all holding company senior unsecured obligations at BBB+.

"Although the merger of the Travelers and St. Paul organizations will provide meaningful benefits related to scale and diversification, Standard & Poor's maintains its overriding concerns about the adequacy of St Paul's loss reserves and the inherent volatility of St. Paul's operating results," explained the statement.

"Standard & Poor's has concluded that St. Paul's carried reserves could still be 3 percent - 5 percent deficient following St. Paul's January 2004 announced $350 million reserve strengthening for its health care business."

Wilt said the action was significant because, in the eyes of most industry observers the desirable double-A rating, once lost, is slow to be regained.

"We do not expect this change (should it take place) would have a meaningful adverse impact on Travelers' business opportunities. However, it is difficult to put a positive spin on the likely action. It also makes management's case for the merger a bit more challenging to convey," he suggested.

"It seems that St Paul's loss reserve woes and stretched balance sheet could temper Travelers' financial strength - at least in the eyes of this agency."

Uninspiring results
For its part, Travelers reported operating earnings per share (EPS) of $0.46, 2 cents down on consensus estimates of $0.48. Net income for the quarter came in at $488.7mn, or $0.49 per share, compared to a net loss of $793mn.

The prior year quarter was hit by the group's record $1.3bn after tax asbestos charge, which acted to boost its asbestos reserves to $3.4bn and, in the eyes of many observers, drew a line under the issue (see the January 2003 edition of Insider Week).

Lipp commented: "We had another strong quarter, achieving a level of profitability that is historically among the top tier in our industry. We are very pleased with our new business volumes and continue to benefit from the positive rate environment."

Fourth quarter performance was also influenced by $203.5mn non-asbestos-related prior year reserve development in the group's commercial lines business.

The charge, net of reinsurance and tax, comprised $163.8mn relating to specialty insurance written by subsidiary Gulf Insurance, $74.8mn from run-off operation American Equity, and $38.9mn arising from environmental coverages.

Offsetting the adverse development was favourable development on prior year commercial property business.

Bault said that in light of the reserve charge, equivalent to $0.20 per share, $0.46 EPS was a good result. "In other words, Travelers took a pre-tax reserve charge of $315mn, nearly the same as St Paul, yet almost met consensus," he commented.

"We consider this result high quality on the underlying earnings, although we suspect the market will not take the miss or the charge well today. While we are not changing our 2004 estimate of $1.95, there may be upside given the reserve actions this year," he continued.

However, William Wilt of Morgan Stanley described the operating trends as "uninspiring".

Wilt welcomed the recorded investment income 14 percent above estimates, as well as commercial retentions and rate increases, but was less complimentary of the unexpected reserve charge.

"Moreover, unlike its pending partner, St Paul, at least some portion of the reserve charge at TAP (Travelers) was in active lines of business where current pricing decisions are a function of the quality of loss reserves," he said.

Travelers also benefited from favourable prior year development in personal lines. Of the $65.9mn net of reinsurance and tax, $32.5mn arose from a reduction in 9/11 reserves, and the rest from an improvement in claim frequency from homeowners and non-bodily-injury automobile business.

Looking for upside
But with momentum towards a successful merger gathering, observers continue to finger St Paul as the winner in the deal. Wilt had commented in November that with the deal likely to complete at a minimal discount (or premium), "the marginal transfer of wealth was to SPC (St Paul) bond and equity holders."

In the wake of recent announcements, Wilt added: "In our view, SPC will benefit from the imputed financial strength of Travelers while rating agency pressure should wane. So long as the merger is successful, the risk of multiple compression in 2004 should be no greater for SPC/TAP than it will be for other insurers."

Bault recognized that the combined company will be "one of the best standard commercial writers in the business, and that this business will likely produce strong profitability for longer than many people think".

"But against this, St Paul/Travelers is presenting investors with integration risk for not much upside compensation. We do not completely agree with the strategic rationale for the merger, and in fact think both companies could easily accomplish their goals separately. To get interested, we would need more upside or a reason to think that risk is lower, neither of which we have at present.

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